On July 22, 2015, the IRS and Treasury Department issued proposed regulations addressing when a share of partnership income and distributions is treated as a disguised payment for services taxable as ordinary income. The proposed regulations in particular focus on management fee waivers, used primarily in the private equity fund industry. The regulations are proposed to be effective for arrangements entered into or modified after the issuance of final regulations. To the extent an arrangement permits a service provider to waive all or a portion of its fees for any period after the arrangement is created, the arrangement is considered to be modified for purposes of the effective date on the date or dates the fee is waived.

The IRS and Treasury Department also announced in the preamble to the regulations an intended change to the safe harbor in Revenue Procedure 93-27, which is generally relied on by taxpayers to take the position that the receipt of a profits interests in exchange for waiving management fees is not a taxable event.

Although the structure of management fee waivers varies, one common form allows the fund manager to elect to waive on a periodic basis future management fees, with the general partner or a special limited partner receiving a corresponding profits interest. In some cases it is the fund manager that receives the profits interest in exchange for the waived management fee.

Under the proposed regulations, an arrangement involving the receipt of partnership allocations and distributions by a service provider will be treated as a disguised payment for services if all of the following apply:

The determination of whether an arrangement is a payment for services is based on all the facts and circumstances. The regulations include a non-exclusive list of six relevant factors. The most important factor is whether the allocation and distribution is subject to significant entrepreneurial risk. The determination of whether an arrangement lacks significant entrepreneurial risk is based on the service provider's entrepreneurial risk relative to the overall entrepreneurial risk of the partnership.

The following factors create a presumption that an arrangement lacks significant entrepreneurial risk:

The five additional factors relevant to the facts and circumstances analysis include:

Example 6 of the proposed regulations describes a management fee waiver arrangement that does have significant entrepreneurial risk. In the example, the general partner contributes 1% of the capital, is entitled to 20% of future fund profits and gains and a related management company is entitled to an annual 2% management fee. The partnership agreement allows the management company to irrevocably waive its fee at least 60 days prior to the taxable year for which the fee is payable, in exchange for an interest in future partnership net income and gains approximately equal in value to the estimated present value of the waived fee. The management company has a clawback obligation. The example concludes that allocations to the general partner and the management company are not arrangements that constitute a payment for services.

Important facts in Example 6 include:

The preamble to the proposed regulations also notes a change that the IRS and the Treasury Department intend to make to Revenue Procedure 93-27. This revenue procedure generally provides that the receipt of a profits interest for services is not a taxable event unless either the:

In structuring management fee waivers, taxpayers have generally relied on the safe harbor in Revenue Procedure 93-27 (as modified by Revenue Procedure 2001-43) to take the position that receipt of a profits interest in exchange for the waiver of a management fee is not a taxable event.

The IRS and Treasury Department intend to provide an additional exception to the safe harbor in Revenue Procedure 93-27. The additional exception will apply to a profits interest issued in conjunction with a partner waiving payment of an amount that is substantially fixed (including a typical fund management fee) for the performance of services. This proposed exception to the safe harbor would appear to apply even if the management fee waiver arrangement is found to have significant entrepreneurial risk. This change would mean that the issuance of profits interests in exchange for many common types of management fee waivers would be subject to potential valuation issues and may discourage fund managers from waiving management fees or structuring new management fee waivers.

In the Preamble to the proposed regulations, the IRS and Treasury Department also state that Revenue Procedure 93-27 does not currently apply to management fee waivers where the management company waives the fee and a related company (typically the fund's general partner) receives an interest in future fund profits because: